Reviewed by Chip Stapleton
Using your money to buy different investments may seem easy, but becoming a successful investor is deceptively tough.
Many retail investors—those who aren’t investment professionals—lose money every year. There could be a variety of reasons why, but there is one that every aspiring investor understands: there’s not enough time to research many stocks, and it’s hard to know what information to look for.
In essence, if you don’t do enough research, you’ll end up suffering losses. That’s the bad news. The good news is you can cut down the losses as well as the amount of research you need to do by looking at some key factors of investing. Learn more about the five essentials of investing below.
What to Know Before Investing in Stocks
- What Stocks Do: Research companies fully—what they do, where they do it, and how.
- P/E Ratio: Look for the company’s price-to-earnings (P/E) ratio—the current share price relative to its per-share earnings.
- Beta: A company’s beta can tell you how much risk is involved with a stock compared with the rest of the market.
- Dividend: If you want to park your money, invest in stocks with a high dividend.
- The Chart: Although reading charts can be complicated, learning to spot simple cues can help you understand a company’s financial health and price trends.
1. What Stocks Do
Investors should avoid purchasing a stock unless they have an exhaustive knowledge of how the company makes money. What do they manufacture? What kind of service do they offer? In what countries do they operate? What is their flagship product, and how is it selling? Are they known as the leader in their field? Approach doing research the same way you’d approach a first date. While you can find true love on a blind date, you’re equally, if not more likely, to leave disappointed.
Company information is very easy to find. Using the search engine of your choice, go to the company website and read about them. Then, go to a family member and educate them on your potential investment. If you can answer all of their questions, you know enough.
2. Price-to-Earnings (P/E) Ratio
Imagine for a moment you were in the market for somebody who could help you with your investments. You interview two financial advisors. One has a long history of making people a lot of money. Your friends have seen a big return from this financial advisor, and you can’t find any reason why you shouldn’t trust them with your investment dollars. They tell you that for every dollar they make for you, they are going to keep 40 cents, leaving you with 60 cents.
The other financial advisor is just getting started in the business. They have very little experience and, although they seem promising, they don’t have much of a track record of success. The advantage of investing your money with this financial advisor is that they are cheaper. They only want to keep 20 cents for every dollar they make you. But what if they don’t make you as many dollars as the first financial advisor?
Note
You can calculate the P/E ratio by dividing a company’s market value per share by its earnings per share.
If you understand this example, you understand the price-to-earnings (P/E) ratio. These ratios are used to measure a company’s current share price relative to its per-share earnings. The company can be compared with other, similar corporations so that analysts and investors can determine its relative value. So if a company has a P/E ratio of 20, this means investors are willing to pay $20 for every $1 per earnings. That might seem expensive, but not if the company is growing fast.
The P/E can be found by comparing the current market price with the cumulative earnings of the last four quarters. Compare this number with other companies similar to the one you’re researching. If your company has a higher P/E than other similar companies, there had better be a reason. If it has a lower P/E but is growing fast, that’s an investment worth watching.
3. Beta
Beta sounds more complicated than it is. It measures volatility, or how moody your company’s stock has acted over the last five years. In other words, it measures the systemic risk involved with a company’s stock compared with that of the entire market. You can usually find the beta value on the same page as the P/E ratio when reviewing stock research pages such as those found at Yahoo or Google.
Think of the S&P 500 as a pillar of stability. If your company drops or rises in value more than the index over a five-year period, it has a higher beta. With beta, anything greater than one is high—meaning higher risk—and anything lower than one is low beta or lower risk.
Beta says something about price risk, but how much does it say about fundamental risk factors? You have to watch high-beta stocks closely because, although they have the potential to make you a lot of money, they also have the potential to take your money. A lower beta means that a stock doesn’t react to the S&P 500 movements as much as others. This is known as a defensive stock because your money is much safer. You won’t make as much in a short amount of time, but you also don’t have to watch it every day.
4. Dividend
If you don’t have time to watch the market every day, and you want your stocks to make money without that kind of attention, look for companies that pay dividends. Dividends are like interest in a savings account—you get paid regardless of the stock price. Dividends are distributions made by a company to its shareholders as a reward for its profits. The amount of the dividend is decided by the company’s board of directors and is generally issued in cash, though some companies issue dividends in the form of stock shares.
Dividends mean a lot to many investors because they provide a steady stream of income. Most companies issue them at regular intervals, typically quarterly. Investing in dividend-paying companies is a very popular strategy for many traditional investors. They can often provide investors with a sense of security during times of economic uncertainty.
The best dividends are normally issued by large companies with predictable profits. Some of the most well-known sectors with dividend-paying companies include oil and gas, banks and financials, basic materials, healthcare, pharmaceuticals, and utilities. Dividends of 6% or more are not unheard of in high-quality stocks. Meanwhile, early-stage companies, such as startups, often do not have enough profitability to issue dividends.
But before you purchase stock shares, look for the company’s dividend rate. If you simply want to park money in the market, invest in stocks with a high dividend.
5. The Chart
There are many different types of stock charts. These include line charts, bar charts, and candlestick charts—charts used by both fundamental and technical analysts. But reading these charts isn’t always easy. In fact, it can be very complicated. Learning to read them is a skill that takes a lot of time to acquire.
So what does this mean to you as a retail investor? You don’t have to overlook this step. That’s because the most basic chart reading takes very little skill. If an investment’s chart starts at the lower left and ends at the upper right, that’s a good thing. If the chart heads in a downward direction, stay away and don’t try to figure out why.
There are thousands of stocks to choose from without picking one that loses money. If you really believe in this stock, put it on your watch list and come back to it at a later time. There are many people who believe in investing in stocks that have scary-looking charts, but they have research time and resources that you probably don’t.
How Much Should I Invest?
The amount you should invest in stocks varies depending on your personal circumstances and investing timeline. Many investors choose not to invest in stocks entirely, preferring to put their money in diversified assets like ETFs or mutual funds. That said, you should ideally invest as much as you can after paying for your daily living expenses and emergency savings.
When Should I Invest?
Most financial professionals recommend starting to invest at a young age to capitalize on compound growth. Based on historical returns of the S&P500, it takes most investors between 6 and 7 years to double their investment. However, this doesn’t mean you should avoid investing just because you’re starting later in life. Ultimately, performance depends on the positions you pick and overall market forces, which is why you should spend most of your time researching stocks.
Are Stocks Risky?
Investing in stocks is inherently risky. At worst, the underlying company goes bankrupt, the stock price tanks to zero, and you lose your entire investment. You can limit your risk by diversifying your assets, such as purchasing stocks in different industries, market caps, and regions. By diversifying your portfolio, you limit the likelihood that all your assets perform poorly in the event of a market downturn or black swan event.
The Bottom Line
Nothing takes the place of exhaustive research. However, one key way to protect your assets is to invest for the longer term by taking advantage of dividends and finding stocks with a proven record of success. Unless you have the time, risky and aggressive trading strategies should be avoided or minimized.